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Chapter 01 - Investments: Background and Issues
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
CHAPTER ONE
INVESTMENTS: BACKGROUND AND ISSUES
INTRODUCTION TO THE INSTRUCTOR’S MANUAL
Welcome to the Instructor’s Manual (IM) for the tenth edition of the Essentials of Investments
text by Bodie, Kane, and Marcus. This market-leading text provides comprehensive information
on investments. Designed to prepare students for a career in the investment industry, it also
serves as an excellent resource for investment knowledge that every individual can use in making
personal-investing decisions.
All data has been updated and sections added that cover new information on topics such as the
causes and effects of the financial crisis of 2008 and the subsequent recovery; the hedge fund
Chapter 01 - Investments: Background and Issues
CHAPTER OVERVIEW
The purpose of this book is to a) help students in their own investing and b) pursue a career in
the investments industry. To help accomplish these goals Part 1 of the text (Chapters 1 through
4) introduces students to the different investment types, the markets in which the securities trade
and to investment companies. In this chapter the student is introduced to the general concept of
LEARNING OBJECTIVES
After studying this chapter, students should have an understanding of the overall investment
process and the key elements involved in the investment process such as asset allocation and
CHAPTER OUTLINE
1. Real versus Financial Assets
PPT 1-2 through PPT 1-4
Investing involves sacrifice. One gives up some current consumption to be able to consume
more in the future (or to be able to consume at all in the future if the goal is simply capital
preservation). Financial assets provide a ready vehicle to transfer consumption through time.
There may be more appropriate investments than real assets for many investors. The distinctions
2. A Financial Assets
PPT 1-5 through 1-6
Fixed-income securities include both long-term and short-term instruments. The essential
element of debt securities and the other classes of financial assets is the fixed or fixed-formula
3. Financial Markets and the Economy
PPT 1-7 through PPT 1-14
Do market prices equal the fair-value estimate of a security’s expected future risky cash flows,
all of the time, some of the time or none of the time?
This question asks whether markets are informationally efficient. The evidence indicates that
markets generally move toward the ideal of efficiency but may not always achieve that ideal due
to market psychology (behavioralism), privileged information access or some trading cost
advantage (more on this later).
A related question may be stated as “Can we rely on markets to allocate capital to the best uses?”
$19.18.
• Yahoo rejected the offer, holding out for $37 a share.
• Billionaire Carl Icahn led a proxy fight to seize control of Yahoo’s board and force the
firm to accept Microsoft’s offer.
• He lost, and Yahoo stock fell from $29 to $21.
• Did Yahoo managers act in the best interests of their shareholders?
The answer to this question really revolves around whether you believe stock prices reflect the
long-term prospects of firm performance or are focused primarily on short-term results. Despite
some long-time periods to the contrary, stock prices do tend to conform to their fundamental
Chapter 01 - Investments: Background and Issues
Corporate Governance and Ethics
Businesses and markets require trust to operate efficiently. Without trust additional laws and
regulations are required and all laws and regulations are costly. Governance and ethics failures
have cost our economy billions if not trillions of dollars and, even worse, are eroding public
4. The Investment Process
PPT 1-15 through 1-16
The two major components of the investment process are described in PPT 1-15, namely asset
5. Markets are Competitive
PPT 1-17 through PPT 1-20
Previewing the concept of risk-return trade-off is important for the development of portfolio
theory and many other concepts developed in the course. The discussion of active and passive
management styles, is in part, related to the concept of market efficiency. The discussion of
6. The Players
PPT 1-21 through PPT 1-27
Chapter 01 - Investments: Background and Issues
Some of the major participants in the financial markets are listed in PPT 1-20. Governments,
households and businesses can be issuers and investors in securities. Investment bankers bring
7. The Financial Crisis of 2008
PPT 1-27 through PPT 1-36
Antecedents of the Crisis
From 2001 to 2004 the Federal Reserve aggressively lowered interest rates. In 2007 the TED
Spread, which measures the spread between LIBOR and Treasury-bill rate, common measure of
credit risk, was around .25%, which is low.
Changes in Housing Finance
Low interest rates and a stable economy created a boom in the housing market, and drove
investors to find higher-yield investments. In the 1970s Fannie Mae and Freddie Mac bundled
mortgage loans into tradable pools by a process called securitization. The securitization model
led to the development of subprime loans (loans above 80% of home value, with no underwriting
Chapter 01 - Investments: Background and Issues
Mortgage Derivatives
Investment banks used risk-shifting tools to carve AAA securities from “junk” loans. The
securities were called CDO’s, or Collateralized Debt Obligations, and they consolidated the
Credit Default Swaps
Credit Default Swaps also contributed to the financial crisis. Credit default swaps are insurance
contracts against the default of borrowers. However, many CDS issuers ramped-up their risk
The Rise of Systemic Risk
Systemic Risk is the risk of breakdown in the financial system, particularly due to spillover
effects from one market into others. By 2007, banks were highly leveraged, with increasingly
The Shoe Drops
On September 7, 2008 Fannie Mae and Freddie Mac were put into conservatorship. By the
second week of September both Lehman Brothers and Merrill Lynch verged on bankruptcy. On
Dodd-Frank Reform Act
The Dodd-Frank Reform Act imposes stricter rules for bank capital, liquidity, and risk
